Return of the “Quiet” Municipal Market

The municipal bond market, as measured by the Barclays Municipal Bond Index, has moved along at a slow and steady pace this year in contrast to the gyrations in the taxable market. Recent market action harkens back to years gone by when the municipal bond market was known as the “quiet” bond market. Taxable bonds would garner the bulk of media attention and municipal bond price movements were much less volatile and newsworthy than those of their taxable counterparts. Of course, the financial crisis that began in 2007 changed all that and the municipal market was one of several sectors that witnessed unprecedented volatility and attention. In 2009, the municipal market recouped much of that damage and so far, in 2010, the municipal market appears to have resumed its “quiet” demeanor.

Through February 22, the total return of the Barclays Municipal Bond Index, 1.18%, is slightly more than that of the broader taxable market as measured by the Barclays Aggregate Bond Index, 1.11%. However, since total return is comprised of both price changes and interest income, the municipal bond market has outperformed by even more after taking into account the impact of taxes. Additionally, municipal bonds provided a smoother ride, in terms of total return, relative to the taxable market.

Muni Bond Performance

Reduced Volatility

The reduced volatility of the municipal bond market can also be seen by comparing 10-year Treasury and Municipal Bond yields. Since the start of the year, the average 10-year AAA municipal yield has held in a very narrow 0.08% (3.03% to 3.11%) yield range compared to the 0.27% yield range (3.56% to 3.83%) on the 10-year Treasury note. Of particular interest, average 10-year municipal yields have held relatively resilient while the 10-year Treasury yield has increased since early February. In our 2010 Outlook, we forecast municipal bond yields to be resistant to higher Treasury yields and we expect that trend to continue.

The main reason for a steadier municipal bond market has been a return to more normal relative valuations. The primary relative valuation barometer simply measures municipal yields as a percentage of Treasury yields. The higher the percentage (or ratio) the cheaper municipal bonds are relative to Treasuries and vice versa. Since peaking in December 2008, Municipal-to-Treasury yield ratios have declined as financial markets have recovered and valuations have returned to levels in line with historical averages with the exception of Shorter-Term Municipals, which are now below the long-term average . We remain underweight Short-Term Municipal Bonds due to more expensive valuations and prefer intermediate and long-term municipal exposure among high quality municipal bonds.

Average AAA Muni Bond Yields

Credit Quality Concerns

Municipal credit quality concerns have been far from quiet, but we continue to believe that fears over widespread municipal bond defaults are overblown. Given the severity of the recession, it is no surprise that states and municipalities face budget shortfalls and that municipal bond defaults have increased. However, looking closer at the numbers reveals a different story than the gloom and doom forecasts portrayed in the media. Since July 1, 2009, $5.3 billion of municipal debt has defaulted according to Municipal Market Advisors (MMA). Of that total, $4.3 billion was non-rated to begin with, leaving $1 billion among rated bonds that have defaulted across a mere 11 issuers. On a dollar value basis, the $1 billion in defaults compares with an overall municipal market of $2.7 trillion according to the Securities Industry and Financial Markets Association (SIFMA). On a percentage basis this suggests that a small 0.04% ($1 billion divided by $2.7 trillion) default rate, if you incorporate both Investment-Grade and High-Yield Municipals.

On a positive note, the pace of defaults has started to slow, similar to what is occurring in the taxable High-Yield Bond market, as the number of municipal issuers reporting defaults and credit impairments is declining on a weekly basis according to Municipal Securities Rulemaking Board filings. Furthermore, the bulk of defaults have occurred among non-rated, housing-related bonds with Florida based issuers leading overall defaults by a notable margin according to MMA. This is not surprising given the well known speculative real estate excesses that occurred in the state. Defaults among higher rated bonds have been very rare thus far. Moody’s Investor Service recently updated their long-term study of municipal defaults from 1970 through early 2009 and found that only 54 rated municipal bond issuers defaulted since 1970, a staggeringly low number. Three-quarters of issues that defaulted came from the housing and hospital sectors. We do not dismiss default risks and expect defaults to continue. However, in keeping with historical precedent and the data reported thus far, we do expect defaults to remain concentrated among the most speculative and non-rated issues.

We continue to find municipal High-Yield Bonds attractive based on a slower pace of defaults noted above and attractive valuations. With an average yield of 7.1%, according to the Barclays Municipal High Yield Municipal Index, High-Yield Municipal Bonds have an after tax-yield of 10.9% (using a 35% top tax rate), well above the 9.2% yield of the taxable high-yield market according to the Barclays High-Yield Bond index.

Favorable Backdrop Still Intact

We continue to have a positive bias on Intermediate and Longer-Term Municipal Bonds, relative to short-term bonds, as the favorable backdrop we have cited in prior publications remains intact. Specifically, Longer-Term Municipal Bonds have been more attractively valued given the prospect of higher tax rates at the end of 2010. Higher tax rates could lead to even higher municipal valuations and we would not be surprised to see municipalty-Treasury yield ratios decline below long-term historical averages. During President Clinton’s two terms, Municipal-to-Treasury ratios were below the current long-term average simply due to the higher tax rates in existence then. In addition, the supply-demand balance remains favorable for investors as the Build America Bond (BAB) program continues to siphon away new issuance that would normally target the traditional tax-exempt market thereby reducing the availability of tax-exempt bonds, particularly among longer maturity issues. Finally, shifting demographics imply greater investor demand for Municipal Bonds on a longer-term basis.

Conclusion

While “noise” on municipal credit quality will likely persist for all of 2010, we find High-Yield Municipals attractively valued and poised to potentially benefit from further moderation in defaults. Among high quality Municipal Bonds, we prefer Intermediate and Longer-Term Municipals but expect further improvement to come more slowly as valuations have reversed
most of the damage of 2008 and Municipal-to-Treasury ratios are in line with historical norms. A return to the “quiet” municipal market performance of old would suit municipal bond investors just fine.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fi xed rate of return and fi xed principal value. However, the value of funds shares is not guaranteed and will fluctuate.

The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.

High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part

of the diversified portfolio of sophisticated investors. Municipal bonds are subject to availability, price and to market and interest rate risk is sold prior to maturity.

Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax.

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specifi c individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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